Private equity firms took notice when President Trump targeted the tax treatment of so-called “carried interest” during his presidential campaign. Not surprisingly, the sweeping federal income tax legislation that was signed into law at the end of 2017 includes a provision that tightens the carried-interest rule — and the IRS has announced plans to toughen the rules even further.

Three-Year Holding Period

Investors typically compensate private equity firms by paying a 2% annual fee on assets under management, plus 20% of the profits. The interest in the profits is carried over from year to year until a cash payment is made — this is known as a “carried interest.” Before passage of the Tax Cuts and Jobs Act (TCJA), a carried interest was taxed as a long-term capital gain, rather than ordinary income, if it was held for at least one year.

Many private equity firms initially worried that the carried-interest tax break would be eliminated as part of congressional tax reforms. So far, that hasn’t happened.

However, the TCJA does extend the holding period from one year to three years. Starting in 2018, if a carried interest isn’t held for at least three years, the gain is treated as a short-term gain — and it’s taxed at ordinary income rates. Under the new law, long-term gains are taxed at a top rate of 23.8% (including the 3.8% net investment income tax), while the top ordinary income tax rate is 37%.

Private equity firms often hold their investments for several years, so a three-year holding period won’t cause every deal to lose tax-favored capital gains status. However, many firms are concerned about the trend favoring tougher carried-interest rules.

No Exception for S Corporations

Section 1061 of the Internal Revenue Code, the new provision that extends the holding period, states that it doesn’t apply to partnership interests held by “a corporation.” Some private equity firms interpreted this exception to mean that partnership interests held by an S corporation wouldn’t be subject to the extended holding period.

So, in the wake of the TCJA, some private equity firms have formed single-member limited liability companies (LLCs) and elected to treat them as S corporations, in hopes of avoiding the three-year holding period requirement. But the IRS recently shot down this strategy.

In March 2018, the IRS announced plans to issue regulations that will clarify that the word “corporation” in Sec. 1061 doesn’t include S corporations. The regulations will be effective for taxable years beginning after December 31, 2017, the same general effective date as Sec. 1061.

Proceed with Caution

Private equity firms contemplating restructuring or other significant shifts in response to changes under the TCJA should discuss their situation with our tax professionals. Additional IRS guidance is expected in the coming months that could further limit the benefits of the new tax law.